Sunday, August 26, 2012

Aaargh! Monetary policy is not "tight"

It is certainly true that the nominal interest rate is not a sufficient statistic for the stance of monetary policy, but a low interest rate is NOT somehow prima facia evidence of tight policy!

Let's take an example of how the nominal rate alone is not enough to infer the stance of policy.  If the interest rate is 10% and inflation is running at 20%, the real interest rate is -10% and policy is not tight. If that same 10% interest rate is paired with a 0% inflation rate, then policy would be very tight indeed (real rate of 10%).

So the nominal rate does not in general accurately guide us to a conclusion about monetary policy.

But now consider our current situation. Inflation is around 2%. The Fed has pushed short term rates to around zero. The short term real rate is negative. 10 year government bonds are yielding around 1.6%, so that 10 year rate is slightly negative. According to the email spam I constantly get, 30 year mortgage rates are something like 3.5%, so the real cost of funds to buy a house is 1.5%. That's not negative, but it is low.

Real interest rates that are negative to very low = monetary policy is not tight!

Could monetary policy be even looser? Maybe.

Would it help? Maybe.

If by QE3 the Fed could get mortgage rates down 50 basis points without raising inflation, making the real cost of funds to buy a house fall to 1% would that solve our economic problems? If the Fed could raise inflation expectations to 3% while somehow keeping nominal rates where they are, would that solve our economic problems?

As LeBron pointed out, the costs of trying and failing don't seem to be so high, so why not give it a try? Just don't expect too much.

And please stop railing about tight monetary policy in the US.


Norman said...

I'm fairly convinced at this point that terms like "tight" and "loose" are just not very useful language to describe monetary policy. Similarly, there's no such thing as "holding policy constant."

The correct use of these terms changes depending on whether the policy objective is the size of the balance sheet, short-term nominal rates, short-term real rates, long-term nominal or real rates, the CPI inflation rate, the core PCE inflation rate, some indicator of aggregate demand like nominal GDP, or any other target. I think the last four or five years have effectively proven that economists disagree strongly about which target is the right one.

And of course, the more layers between the Fed's balance sheet and the target, the more relationships the Fed has to be able to quickly react to in order to "tighten" or "loosen" policy.

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John Thacker said...

FWIW, Menzie Chinn here argues that long term real interest rates were negative during the Great Depression, starting in 1930.

You thus would seem to be arguing that monetary policy was not tight during the Great Depression, if those figures are correct.

Unknown said...

The past and present policies like monetary policy of the Government and the Fed have harshly destabilized the economy’s ability to produce wealth.

You can read the impact of monetary policy in Ed Butowsky recent article posted in Fox Business News, "Obama Chose Monetary Policy - And You're Feeling It".